Executive SummaryThe composition of the tax base—or what gets taxed—will be one of the major issues that the President’s Advisory Panel on Federal Tax Reform will have to grapple with in its report due to be released in November 2005.

In recent years there has been growing interest in abandoning the system of taxing income altogether and replacing it with a system that taxes consumption. In other words, the panel might propose a tax system that would tax actual consumption rather than changes in the ability to consume, which is what occurs under an income tax. There is much merit in such a proposal. However, as long as the nation keeps its conventional income tax, it could levy the tax in a much more comprehensive manner.

The current federal individual income tax system taxes less than half of the income that potentially could be taxed. This results in tax rates that are more than twice as high as they could be. Moreover, when we tax some income heavily and some not at all, taxpayers naturally change their financial activities. Often these changes are economically nonsensical, but they make tax sense. The combination of high tax rates and tax-induced economic distortions harms the nation’s economic performance and lowers the U.S. standard of living.

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